Public Information Notice No. 05/120

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Mozambique

September 6, 2005

On June 22, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Mozambique.¹

Background

Mozambique's strong commitment to sound macroeconomic policies and structural reform has led to a remarkable improvement in economic performance, supported by substantial donor assistance. During the last decade, real GDP growth averaged 8 percent a year (the highest in Africa), end-period inflation was reduced to single digits, public external debt shrank, the international reserves position strengthened, and the share of the population living in absolute poverty declined substantially. These achievements were facilitated by a stable political situation and the consolidation of the democratic system, as illustrated by the recent general elections that took place peacefully.

The economy continued to perform well in 2004. Real GDP growth decelerated slightly to an estimated 7.2 percent. Despite a sharp increase in petroleum prices, inflation declined more than expected to 9.1 percent at end-December 2004 and to 4.5 percent at end-April 2005 driven by lower food prices. The easing of inflation expectations also contributed to a reduction in interest rates. Strong growth in traditional exports, the completion of two megaprojects, and improved terms of trade helped narrow the external current account deficit, excluding grants, by one third to 13.8 percent of GDP in 2004. This, together with greater-than-anticipated donor support and large private capital inflows, contributed to boost net international reserves, well above program, to about six months of imports. This led to a strong appreciation of the metical in real effective terms in 2004.

Performance under the Fund-supported program was mixed. All quantitative performance criteria, except the one pertaining to the government domestic primary deficit, were met. The revenue to GDP ratio decreased from 12.9 percent of GDP in 2003 to 12.3 percent in 2004 and fell short by 1.1 percent of GDP of the program indicative floor for end-December 2004 (using the new GNP series). Collection of most taxes turned out lower than envisaged. The revenue shortfall was mainly due to higher-than-projected VAT reimbursements related to megaprojects, delays incurred by corporations in complying with the payments calendar under the new corporate income tax code, and the impact of the appreciation of the metical. Another important factor was the weakening of tax collection during the transition period leading the nomination of a new government. The revenue shortfall was partially compensated by cuts in current expenditures. However, the share of priority expenditures to total expenditure (about 63 percent) was slightly lower than programmed. As a result, the domestic deficit fell short of the program target by 0.7 of GDP and the overall fiscal deficit, after grants, was slightly higher than envisaged.

Broad money growth slowed down significantly in 2004, reflecting in part the impact of the appreciation of the metical on the foreign currency deposits. In the midst of the commercial banks restructuration, the increase in domestic credit to the private sector remained relatively modest while net credit to the government was slightly exceeded. However, the end-December indicative stock of reserve money was exceeded by a small margin, owing mainly to a larger-than-expected demand for domestic currency. In 2004 and early 2005, the Bank of Mozambique (BM) took several steps to strengthen monetary management, including a more judicious mix of its monetary instruments in the context of a managed floating exchange rate system. Since the second half of 2004, it has relied more on foreign exchange sale to control liquidity, following the heavy reliance on domestic monetary instruments.

Progress in implementing structural reforms has been slower than envisaged. In particular, five out of eight benchmarks were missed, while one of the two structural performance criteria was not observed, including in the monetary and fiscal areas.

Implementation of fiscal reforms has continued but with some delays. A draft general tax law and a law creating the Central Revenue Authority (CRA) were submitted to the Assembly in mid-2004 but have not yet been adopted. Progress has been made to facilitate the merger of the General Directorates of Domestic Taxes (DGI) and Customs (DGA) into the CRA by end-2005. On the expenditure side, at the beginning of 2005, the new electronic financial administration system (e-SISTAFE) began to record and classify all disbursements to line ministries. In addition, work is progressing to strengthen the functioning of the Treasury Single Account (TSA). In this context, the transactions between the BM and commercial banks are now reconciled on a daily basis.

Key structural measures in the banking system are also being implemented. Nonperforming loans have declined sharply. The BM has finalized a timetable to adopt International Financial Reporting Standards (IFRS) in the banking system and bring loan classification and provisioning in line with best international practices. The reviews of the four largest banks, finalized in February 2005, show that they are ready to move to IFRS. The regulations of the newly adopted Financial Institutions Law were approved by the Council of Ministers in late 2004, and the revision of the regulatory framework for microfinance activities was completed.

Reforms in other sectors have encountered some difficulties. Reforms in the judicial system were hampered by capacity constraints and delays in approving relevant legislation. The creation of a financial investigation unit was delayed due to the pending amendment of the current anti-money laundering law. Progress on land tenure reform was hindered by the difficulty of gathering consensus on such a sensitive issue. The new procurement legislation was not approved due to delays related to the consultation process.

Executive Board Assessment

Executive Directors noted that Mozambique is at a critical juncture in its development. After its impressive performance of the past decade, a second wave of reforms is needed to deepen and accelerate structural changes to sustain high and broad-based growth. The authorities' strong commitment to follow through with the needed reforms will help ensure that the remarkable results the country has achieved so far are not reversed. In that context, Directors emphasized that efforts should aim at (i) increasing tax revenues; (ii) strengthening public sector operations; (iii) reducing the costs of doing business; (iv) promoting labor-intensive sectors; and (v) implementing a rural development strategy.

Directors welcomed the substantial reduction in poverty realized over the past decade. At the same time, they stressed that stepped-up efforts are needed to further reduce poverty and, with the necessary financial assistance of the international community, reach the Millennium Development Goals. In particular, they looked forward to the new poverty reduction strategy paper for 2006-10.

Directors noted that performance under the PRGF-supported program has been mixed. They welcomed the continued strong growth, deceleration in inflation to single digits, and strengthened external position in 2004. Directors, however, regretted important slippages during the period October 2004-March 2005, which coincided with the elections and the installment of the new administration, in particular the weakening of tax collection and delays in the implementation of the structural reform agenda. They welcomed the authorities' commitment to bring the fiscal stance back on track in 2005, by strengthening tax collection, and implementing expenditure contingency measures to preserve priority outlays.

Directors concurred with the authorities' medium-term fiscal consolidation strategy, which rests appropriately on increasing revenue mobilization, moderating the growth of the wage bill, and enhancing public expenditure management. In this regard, Directors encouraged the Mozambican authorities to further improve tax administration procedures, noting that a significant part of potential taxes are not being realized, and to make the budget a more effective instrument of fiscal reporting and management, through the timely rollout of the new electronic financial administration system. The new budget management system should, with the assistance of the donor community, include all project-related expenditures. Directors also encouraged the authorities to increase the share of pro-poor expenditures.

Directors commended the authorities for the steps they had already taken on the revenue side. They noted the progress made in establishing the Central Revenue Authority. They also welcomed the recent approval of the new regulations for tax auditing and inspection. On the expenditure side, Directors expressed concern at further delays in implementing the e-SISTAFE. However, they welcomed its rollout in the Ministry of Finance in late 2004, its use to record and classify all disbursements to line ministries, and the authorities' commitment to roll it out to the Ministry of Education and Culture in 2005. They also noted progress in strengthening the functioning of the Treasury Single Account.

Directors commended the authorities on keeping a prudent monetary policy stance and increasing the flexibility of the exchange rate. Directors noted that the flexible exchange rate regime has helped cushion the impact of exogenous shocks. They encouraged the authorities to continue pursuing a balanced mix of foreign exchange sales and issuance of treasury bills to sterilize excess liquidity. Intervention in the foreign exchange market should be limited to achieving the international reserve target and preventing short-term volatility. Directors welcomed the introduction of foreign exchange auctions. They also noted that there was no evidence of a real effective exchange rate misalignment.

Directors noted the recent improvement in the performance of the banking sector, including the sharp fall in nonperforming loans. They welcomed the authorities' commitment to strengthen the supervisory regime and the reporting practices of the banking system. They encouraged the authorities to continue to divest its ownership in the banking system and urged the authorities to continue their efforts to deepen the financial system by developing microcredit institutions and reforming land tenure titles to facilitate the provision of financial services to rural and urban households. Directors also welcomed the authorities' commitment to strengthen the balance sheet of the central bank.

Directors supported the authorities' renewed efforts to reduce the cost of doing business in Mozambique, expand and diversify the export base, and improve international competitiveness. They welcomed the authorities' plan to further remove the remaining restrictions on the making of payments and transfers for international current transactions. In addition, Directors encouraged the authorities to continue streamlining commercial licensing procedures and reforming labor market regulation, and the judicial system.

Directors strongly encouraged the authorities to reach agreement with bilateral non-Paris Club creditors that have not yet provided debt relief under the enhanced HIPC Initiative. At the same time, creditors' readiness and support in this regard are fundamental. They also encouraged the authorities to secure highly concessional foreign assistance. This, together with increasing tax revenue and the strengthening of the debt-management capacity, should contribute to keeping external and public debts sustainable.

Directors welcomed the authorities' commitment to revive the public sector reform with the help of the World Bank and other donors. They stressed that the reforms of the civil service and procurement legislation are necessary to improve the efficiency of government spending, combat corruption, and ensure appropriate wages for public employees.

Directors appreciated the authorities' renewed efforts to improve governance, which continue to cloud the investment climate. They welcomed the authorities' commitment to amend the anti-money laundering law and create a financial investigation unit. They also praised the authorities for their commitment to publish and disseminate the results of the National Survey on Governance and Corruption.

While welcoming recent improvements in the statistical system, especially in the national accounts series, Directors urged the authorities to continue to strengthen the statistical system, which still has deficiencies that hinder the monitoring of economic development.